All right. I think, we'll go ahead and get started. So welcome to the 3:40 session of day 2. It's still another 4 sessions left, I think, between today and tomorrow. With us for this session, we have Northrop Grumman, and presenting or conversing, I guess, with us today is Jim Palmer, the company's Chief Financial Officer, as well as Steve Movius, the company's VP for IR, and Denny McSweeny is also here from Investor Relations. So I think there are safe harbor statements, which I'll let you do and then we're going to have a conversation.

James F. Palmer

Absolutely. We'll go from there. Well, as you know, we're going to having forward-looking statements that do involve risks. It's probably the first time you heard that and SEC filings are therefore a complete description of those risks.

Question-and-Answer Session

Myles A. Walton - Deutsche Bank AG, Research Division

All right. Having get that out of the way. So Jim, I'm sure you've heard the drinking game word of sequestration a few too many times today. So why don't you give us a realtime update of what you're seeing but more importantly, what you expect to see kind of over the next 3, 6, 12 months as it relates to sequestration, slowdown to the economy numbers?

James F. Palmer

So Myles, I think, first of all, there is probably a misconception of what sequestration really means, and I think that misperception was essentially what I would characterize as an iron curtain. That an iron curtain was going to come down on March 1, and we were going to be dramatically different on March 2 than we were on March 1. Essentially, sequestration and the implementation of it is all around how do we reduce the flow, if you will, of new contracts, the values of new contracts rather than reducing the value of the existing contracts. Also important to understand the way the budget process works. Once we get a budget approved by Congress, that budget gets given or allocated to the various departments, down to the various agencies. Once they have budget authority, then they begin the conversations with us to contract for goods and services. It could take months, years, to actually negotiate a contract. Once we get a negotiated contract, we tend to begin incurring costs and recognize revenues based on those costs. And so there's, if you will, a time lag between reduction in budgets, reduction in contract values and reduction in revenues that occur. Dependent upon the cycle, the period of performance of the contract works. So something like a military aircraft that traditionally might have a 3 to 4-year period of performance. It's going to take longer for those reductions in budgets to be reflected in revenues than it would be some of the shorter cycle businesses where the ability to affect contract authorities, our revenues is more on a shorter cycle business. Shorter cycle. So it's going to vary but, if you will, the benefit of all of this is we tend to have pretty good visibility through the windshield on what's coming our way and to be able to plan for what those reductions might be, all of that predicated upon that, given any unexpected contract terminations, obviously.

Myles A. Walton - Deutsche Bank AG, Research Division

So when you go into a year, you usually have a pretty healthy funded backlog that supports the full year forecasts. As you look at what's going to be booked through the rest of this year and you end up with a yearend backlog in 2013, do you think you're going to be in a similar position you've been in the last few years in terms of the covered backlog for the year?

James F. Palmer

As you know, we don't guide to backlog, but we have said publicly that if we had a book-to-bill ratio of about 1 for the year, given the environment we're in, that would be, we think, good performance.

Myles A. Walton - Deutsche Bank AG, Research Division

Yes. I would agree. So let's talk a bit about some of the specific of the portfolio. UAVs, UCLASS or UCAVs made its first carrier launch. Pretty exciting. Talk about that program as a development program or demonstration program that could potentially go into a larger production program. Talk about the long-range strike and the F-35?

James F. Palmer

Right. So Steve, you can help me here, whenever you want. But UCAS demonstration program, and as you commented, the first time ever in the history of aviation that an unmanned vehicle has been launched from an aircraft carrier. So a really important accomplishment, a lot of technology obviously involved in that accomplishment. This vehicle is a true autonomous vehicle. There's not a man in the loop. It's essentially a robot. And not only was it launched from the aircraft carrier, but it's done a number of touch and goes on the aircraft carrier. So this program is all about demonstrating that the capability exist to get on and off an aircraft carrier, the follow-on program is called UCLASS where the intent would be then to take this demonstrated capabilities and to build a vehicle to be essentially based on the aircraft carriers. So we think, given the performance on UCAS, we're well-positioned for the competition on UCLASS that's going to occur here in the next -- over the next year or so.

Stephen C. Movius

Let me jump in on long-range strike because that's a little bit of an interesting phenomena, that the program is classified. So there's not a lot of information out there on it. What I can say is it's very important to the company. We believe it's a priority for the Air Force, and if you look at information that is available in terms of its likely ramp up, there is some interesting financial information in the palm which provides, I think, an interesting timeline for when additional dollars would be committed. Turning over to the F-35, the F-35 is 1 of our 2 largest programs in terms of annual revenue in the $1 billion a year range. We have approximately 20% of the content on that program. The quantities in the current LRIPs, LRIP 5, 6 and 7 are about the same. So from a revenue profile, we're expecting it to be relatively consistent, with -- I mean, for 2014 and '15 to look a lot like 2013. We think the program is doing well where no program -- no performance is perfect, we think we're performing well. And we think it's going to be good for the country, good for locking the growth.

Myles A. Walton - Deutsche Bank AG, Research Division

So just I know the long-range strike is classified, well, classified budget, I guess, but is it unclassified program and exist? Is the teaming marriages decided and is the timeline of when those decisions are made and also when that competition actually takes place?

James F. Palmer

Actually, we can't say any more than what we said.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. All right. In terms of the ability to stay in front of top line revenue declines, you guys have been pretty active in staying in front of those declines, taking out cost ahead of where the revenue is going to be. Talk about some of the opportunities going forward, not just to do that but also to look at the portfolio as a whole and are there areas where you maybe just don't even want to stay in front of it? You don't want to be in it?

James F. Palmer

Well, so a number of questions there, Myles. So let me step back a little bit and observe that 3 years ago or so, we were a $35 billion company and through the spinoff of shipbuilding, the sale of TASC and other businesses that we just decided that didn't meet our return criteria, those activities, those 3 major activities have taken $9 billion of revenue out of our business. And clearly, we've had to scale the company in reaction to that $9 billion of revenues that have gone away. During that time period, we've gone from 9.5% segment operating margin rates to 12.6%. And that's excluding shipbuilding from that 9.5% in 2009. So a tremendous performance by the company and improvement by the company largely as a result of, I think, a combination of factors, starting with thinking about the risk inherent in the program or the contract that you're bidding for, making sure that you had terms and conditions that are reflective of the overall risk of emphasis on good contracts. Clearly knowing what your costs are important because you're estimating cost for a number of years. So having a perspective on cost today, as well as where those costs belong is important for that ability to estimate cost. And then ultimately, managing. Knowing what the -- there's always risk in any contract, there's always opportunities in any contract, but if you don't have a formal process around managing or identifying and managing those risks and opportunities, you're probably going to miss some of the things, some of the risks that are going to become realized, some of the opportunities are going to become missed. So having a formal management process around risk and opportunities, I think, all have contributed to our ability to increase those margins. Clearly, we've had a view for a period of time that we were likely in a declining environment. And so our focus has been on taking actions ahead of time so that we can not only preserve the flexibility we have but actually increase it as we go through time. Clearly, in a period of uncertainty, flexibility is important, so cost reductions ahead of time, planning the pension plans ahead of time. Last 2 weeks ago, we raised an extra $2 billion of debt in favorable capital markets. So all of that is geared towards preserving and increasing the flexibility as we deal with this environment that has some element of uncertainty but also some element of opportunity as well.

Myles A. Walton - Deutsche Bank AG, Research Division

So on the 12% margins, 12.5% margins we've gotten the business to, you have long-term targeted margins which that is in excess of, so what is the opportunity to continue to track it then?

Long time benchmark for our industry, taking a look at the performance, not only of ourselves but all of our major peers and the segments that we are in and essentially through the cycle. So what should this business generate as we look at the performance of the industry through this cycle? Use those as benchmarks to motivate our organization. At one point, we were not doing as well as those benchmarks. Today, we are doing better. Clearly, our incentive compensation systems are geared towards continuing to do better than those benchmarks. Environment is a little bit more difficult, I would admit, than it had been. So the challenge is greater but the team is up to it.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. So I think you've been on the forefront of, I'd say, financial value creation within the defense complex. And I think you've been out, again, in the forefront of that, I mean, your preferred option of returning capital to shareholders has been share repurchase with still a very healthy dividend. And last week, you mentioned $2 billion net proceeds, another $800 million financed -- refinanced. You already had plenty of cash in the balance sheet. You had stated share repurchase authorization program. Should we assume that because of the net proceeds and the cash already in the balance sheet, that, that 25% diluted share count reduction has been pulled forward to the left?

James F. Palmer

I don't know that I would assume that. We basically said that our intent is to retire 25% of the outstanding shares by the end of 2015. I look at that as I have 11 quarters to accomplish that. I can think about the timing of that based on market conditions and have the flexibility and the firepower to deal with any of those situations that may come. So could it be accelerated? Yes, I'd say it could be. May it not be good acceleration? Yes, I could think about that as well. But we will make decisions about the pace and the magnitude of share repurchases based on other value opportunities, as well as what were the prices, I guess.

Myles A. Walton - Deutsche Bank AG, Research Division

But we should have seen that ASRs are a thing of the past, and that's not that path that you'd necessarily choose?

James F. Palmer

No, I would say that's a possibility but we have the flexibility to implement this in any way that we may choose to do so. We have done, as you observe, ASRs in the past. It's really a management on what we're trying to accomplish at that period of time.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. In the past, you've talked about the kind of key areas of Northrop as a franchisee, C4ISR, unmanned, cyber and logistics. Are those 4 pillars still the right pillars?

James F. Palmer

I think so. I would -- not to exclude manned aircraft but I would think manned aircraft is also one of those important pillars for us. We clearly have a significant presence in manned aircraft but our focus areas are those areas that you just mentioned. C4ISR, cyber, unmanned and modernization and upgrades or logistics.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. So let's talk cyber.

James F. Palmer

Yes.

Myles A. Walton - Deutsche Bank AG, Research Division

That's the end of the conversation, right? That's all you have to say. So what can you tell us about Northrop's role in the complex, the size, the growth rate?

James F. Palmer

We have -- cyber is a growth market. One of the challenges in cyber is there is not a common definition for what is included in cyber. So let me give you one that we have used. We tend to think of cyber as both network and non-kinetic activities or electronic warfare. When we look at our portfolio under that definition, about 8% of our revenues are pure cyber activities. A little bit over half is network related, a little bit less than half is electronic warfare related. The network piece is essentially 3 major type of activities that a company could be involved in. Defensive, capabilities, something that we call situational awareness where essentially you develop capabilities to see whether or not somebody is mucking around in your network and you want to see what they're trying to look at. So you may put them off to the side, and I'll let them snoop for a period of time to see what you can learn. And then, obviously, the reverse of defense is offense. And so involvement in those areas are where we're focused on in terms of the cyber activities. And yes, I can't say much more than that.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Well, that's more than I was expecting, so that was a good answer. In technical services, so that piece of your business, as you've consolidated some of the other segments, certainly is the smallest?

James F. Palmer

True.

Myles A. Walton - Deutsche Bank AG, Research Division

And you could argue that the logistics pillar I mentioned, and you elaborated on, it fits under that?

James F. Palmer

Yes.

Myles A. Walton - Deutsche Bank AG, Research Division

But it's something I would also say is probably less core?

James F. Palmer

Yes. So I'm going to disagree with you, if that's okay. And the reason for the disagreement is the logistics or technical services piece of our business is very important front end source of information, much of that activity done in forward basis out with the customers, so the near-term customer input about issues that they're facing, and therefore, what we may do to be able to deal with those issues is important. That's an important piece of that part of business. But also, in a constrained budget environment, traditionally, there's been less new starts. When there's less new starts, the need to upgrade or modernize capabilities, existing capabilities, is a trend that you see. Many times, that trends is updating electronics on various platforms. And so having the market knowledge about what the needs are of the customer, low-cost operations to deal with dismantle, reinstall and then potentially pull-through electronics components is a valuable piece of the business.

Myles A. Walton - Deutsche Bank AG, Research Division

So that brings us to F-16 radar. So can you talk about that upgrade opportunity in the market, when the key decisions could be made? Lockheed is the source selection authority or the buying authority or whatever the technical term is for the U.S. piece. But can you talk about some of the international ones as well?

James F. Palmer

So the opportunity you're referring to this as the upgrade to the radars on F-16, it's a mechanically scanned radar today. AESA upgrade is opportunity that both we and Raytheon are competing for. As you observe, Lockheed is a source selection authority for the U.S. government. There is, I still think, around, or I believe, around 2,400 F-16s in operation on a worldwide basis. Theoretically, many of those are candidates for upgrades to do that new updated radar. Again, an example, the importance of the upgrade opportunity set you're likely to see in a constrained budget environment.

Myles A. Walton - Deutsche Bank AG, Research Division

And in terms of the timeline for the U.S. piece?

James F. Palmer

Second half of this year.

Myles A. Walton - Deutsche Bank AG, Research Division

Second half this year?

James F. Palmer

Yes, I think so.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Any questions from the audience? If not, you'd just think I'm doing great so I'll keep going.

James F. Palmer

There was one over there.

Unknown Attendee

You mentioned the F-35. I thought I saw a picture a couple of weeks ago, about Chinese fighter that looked a lot like to F-35. I was wondering if you might be able to comment on the espionage aspect of China, the damage its done to U.S. security and the potential detrimental effect to the financial stability of the industrial military complex in the United States?

James F. Palmer

I probably should just leave that where you left.

Unknown Attendee

With -- under sequestration, is it possible or could you envision a scenario where the budget cuts hit the lower-tiered players in the space, and I'm not too familiar with your supply chain to know how reliant upon these players you are, but is there potential for these players in the industry to be weakened financially, such that you'd have to come and support or you might have to acquire down where you wouldn't in the value chain normally?

James F. Palmer

All of us who have been in this business for a period of time know that in a downturn in the defense budget environment or our supply chain is an area that requires additional focus, we've been concentrating on that for at least the last year or so. So paying particular attention to the financial capabilities of our supply chain, and at times, you may have to help them out. But it starts with thinking carefully about the quality and the capability of the supply chain and making decisions about whether or not there were other sources available if you had an issue. And then ultimately, you may have to deal with that issue if it does rise. But planning is important in having an understanding of the pressures that your supply chain may be under is an important part of managing the business.

Stephen C. Movius

One that I'll add to that is we also look at, sometimes, we may need to take certain pieces of the business that have been outsourced to naturally bring it back into the company, it's not the first -- the preferred path but we have looked at that as one of our options in terms of dealing with the supply chain that's under duress.

Myles A. Walton - Deutsche Bank AG, Research Division

How much of the current products that you could outsource is outsourced?

Stephen C. Movius

In terms of?

Myles A. Walton - Deutsche Bank AG, Research Division

In terms of either in the services and/or other products areas, you have a decision to make buy? Other companies and electronics space might be 50/50 in that insource versus outsource? Do you have any feel for where?

Stephen C. Movius

I don't have that data.

James F. Palmer

50/50 is not a bad relationship.

Myles A. Walton - Deutsche Bank AG, Research Division

The other area I wanted to ask about was M&A, which that was kind of the question that was leading here. You've been pretty consistent in the message and the actions but it's never a bad idea to ask the question anyway.

James F. Palmer

We have an active M&A organization. We frankly look at everything that comes along. We have sold more businesses recently than we bought, but we did buy business in Australia last year, cyber-related business. So it is an area of interest, the areas that we would be interested in are not surprising. The areas that we just talked about, C4ISR, cyber, unmanned, modernization and upgrade type of activities. So we continue to look. I think there were earlier question was about our portfolio and other opportunities that might be there for divestitures. And although I don't know that there's anything of the magnitude that we have dealt with in the past, it's something that we always look at. Whenever you do that, you're making judgments about how well positioned you are and where you think the customer requirements are going. And so having made those judgments in year 1, it's important to go back the following year or the year after that and verify that your assumptions that you made back then are still valid in the current environment. So it's a process that you're never ever finished with.

Myles A. Walton - Deutsche Bank AG, Research Division

So you've been pretty active in terms of maintaining a stronger portfolio than your -- stronger pension funding division than your peers. And you've also talked about CAS expense and most agree, in defense complex, hopefully, that CAS expense going up is not a good thing necessarily. And it actually starts to work against you from a competitive aspect at some point. So I'm curious, given your pension plan now where it is, looking for it, especially under harmonization and the disparity that others will feel in terms of CAS expense rising, are you starting to see that competitive advantage flow through that you can point to?

James F. Palmer

I don't think you could ever point to a single item as a reason you won a competitive opportunity but it is, clearly, in today's environment, pressures around having a competitive cost structure are as great as they've ever been. Clearly, technical capabilities are very important as well. And whether you can signal out one item as the reason you won or loss is at times very difficult. But on the other hand, having an advantage wherever you can gain it is important. And I think we do have an advantage or competitive posture as it relates to our pension cost on a go-forward basis.

Myles A. Walton - Deutsche Bank AG, Research Division

And can you remind us the pension funding for the next 2, 3, 4 years? And also, squeeze inside of it which is rates increasing. Just remind us of the sensitivity.

James F. Palmer

So all of this has to be qualified by your current set of assumptions. So assuming investment performance equal to our long-term rate of return assumption of 8%, and no change in interest rates, our required contributions this year and the next in '14 and '15 are about $75 million a year. We didn't make any additional voluntary contribution in April of $500 million. Conversely, with CAS harmonization, our CAS costs would go from roughly $500 million this year, let's say $650 million next year, and $800 million the following year. Much of that being CAS harmonization related as opposed to "normal CAS," if you will. So on one hand, we have a potential net cash flow benefit resulting from the prefunding that we've done of our plans over the last number of years. That could be relatively important on a go-forward basis.

Myles A. Walton - Deutsche Bank AG, Research Division

And your pre-funded credits right now?

James F. Palmer

Over $2 billion, rough numbers.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Any questions from the audience? Promise you won't ask another pension. What do you think is the least understood piece of the Northrop story at this point? This is going to be a question for IR?

Stephen C. Movius

No, I would say that...

James F. Palmer

I don't know that -- we've not been as -- I think the market understands the significant change that we've had in our operations. I think the market understands that cash flow or shareholder-friendly position the company is in, I don't know that the market has a full appreciation for the international opportunities that could be in front of us. So for example, we now have approval to sell Global Hawks to South Korea. Congress approved that sale in December last year. We're in the process of negotiating essentially that sale. Getting through the door the first time and answering all the questions and issues associated with that sale of that type of platform is going to make getting through the door the second and the third time easier, because we will have answered all the questions and issues associated with the capability of that platform. The market may not appreciate the international opportunities that are ahead of us. That is an example.

Stephen C. Movius

And I would say corollary to that is that because we have a, quite frankly, a smaller portion of our revenue being international, I think that there's sometimes a surprise that our electronics organization has been an established player in the international marketplace for many, many years, about 20% to 25% of our electronics organization sales are internationally based. So again, we have established infrastructure and relationships and whatnot that we hope to leverage.

Myles A. Walton - Deutsche Bank AG, Research Division

And so, I think, you're probably right. That's not where -- it's probably not the top 5 bullet points that most people often telling on Northrop. So what is the percent target or hypothetical benchmark, I guess, for international that I should think about?

James F. Palmer

We have purposely not put a target out there, Myles, because we have an organization that is very focused on achieving targets and we want this to be quality revenues, quality margins, as opposed to X percent of revenues are going to be from international. And so we'd rather focus on the quality of the business and the quality of the opportunities. At the same time, we are putting additional resources, spending additional resources into a number of countries to take advantage of what we see as opportunities.

Myles A. Walton - Deutsche Bank AG, Research Division

Okay. Any other questions? There's not. I think we're good on time. Great. Well, thanks.

James F. Palmer

Thank you. Appreciate it.

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